Litigation: Preliminary agreements may not be as “preliminary” as you expect

You’ve been negotiating with the other side and have finally nailed down most of the terms. You want to memorialize those terms in a preliminary agreement or memorandum of understanding, but make everything subject to a final written formal document in case you still can’t agree on the final terms. Is an express reservation that the agreement is not final until formalized and executed sufficient to protect you and your company? The answer may depend upon the jurisdiction whose law applies. At the very least, you may have an obligation to continue to attempt to finalize the agreement in good faith. Therefore, it is important to check applicable law before memorializing a preliminary agreement to avoid unintended obligations.

For illustration, we will use New York case law, as applied by the federal courts, as an example. (Notably, there are distinctions between how New York state courts and federal courts address this issue.) In the 2nd Circuit, there are two types of preliminary agreements under New York law: Type I and Type II. Type I agreements are relatively straightforward because they are “complete, reflecting a meeting of the minds on all the issues” and enforceable “even if a more formal agreement never materializes.” In assessing whether parties have entered into a Type I agreement, courts applying New York law will consider four factors:

Whether there is expressed reservation of the right not to be bound in the absence of a writing

Whether there has been partial performance of the contract

Whether all of the terms of the alleged contract have been agreed upon

Whether the agreement at issue is the type of contract that is usually committed in writing

By contrast, Type II agreements, which reflect agreement on certain major terms but leave other terms open for negotiation, do not bind parties to the terms unequivocally. Still, courts in the 2nd Circuit have held that Type II agreements still impose a significant duty upon the parties—the duty to negotiate in good faith. Accordingly, parties should understand that once they have entered into a Type II agreement, they cannot simply walk away if they change their minds or find a better deal, nor can they impose new conditions that are not found in the Type II agreement. In assessing whether parties have entered into a Type II agreement, courts applying New York law will consider five factors, the first of which is the most significant:

Whether the intent to be bound is revealed by the language of the agreement

The context of the negotiations

The existence of open terms

Partial performance

The necessity of putting the agreement in final form, as indicated by the customary form of such transactions

EQT Infrastructure Ltd. v. Smith, a case out of the Southern District of New York, is instructive and provides a cautionary tale for parties to preliminary agreements. In that case, the parties entered into a preliminary agreement while negotiating the sale of some of the defendants’ businesses to the plaintiff. From the outset, the parties understood that the plaintiff, a foreign entity, could not own or operate the defendants’ marine services business, and thus would not purchase it as part of the possible transaction. Notably, the parties’ agreement did not state that the possible transaction was conditioned on the sale of the marine services business to another buyer. After several months of negotiating under what the court presumed to be a Type II agreement, the parties were close on a purchase price for the businesses when the defendants informed the plaintiff that they could not find any buyers for their marine services business. In order to make the transaction economically viable, the defendants requested a 13 percent increase in the purchase price. The court found the imposition of this new condition—the sale of the marine services business to another party—stated a claim for a breach of the obligation to negotiate in good faith under a Type II agreement.

Beyond the 2nd Circuit, the Type I/Type II distinction follows the modern trend in contract law, and many state courts have noted the pragmatism and commercial necessity of recognizing these types of agreements. Although they have yet to be recognized definitively in all jurisdictions, Type II agreements—and the implied duty to negotiate in good faith that accompanies them—are recognized in the 4th and 7th Circuits (under West Virginia and Illinois law, respectively).

In short, before memorializing a preliminary agreement or memorandum of understanding, in-house counsel should understand how the applicable jurisdiction will treat the draft agreement. If the company wants a continuing good faith obligation to negotiate, the draft summary may meet its interests, but otherwise, it may make sense not to memorialize anything unless and until the company is ready to commit.